An Investment Strategy to Save the Planet

If one of your New Year’s resolutions was to do your part against climate change, keep reading. Now you can — with your investments.

You’d be following New York State’s example. At the Paris climate change talks last month, the state’s comptroller, Thomas DiNapoli, announced that the state’s Common Retirement Fund, for public employee pensions, will put $2 billion into a new investment fund created by Goldman Sachs that prioritizes companies with smaller carbon footprints. If that goes well, the retirement fund will put in more.

The Common Retirement Fund is the country’s third-largest pension fund, so it often makes news in the world of institutional investing. But this announcement is also big news for climate change.

Until a few months ago, most investors had to choose between two kinds of green. If they wanted to invest in environmentally friendly companies, they had to accept either higher risk or lower returns. “One of the biggest barriers has been lack of financial products,” said Jamie Henn, a co-founder of the climate activism organization 350.org. “The only green funds have been boutique ones with high rates.” People invested if they were dedicated enough to the environment to pay for the privilege. That kept green investing small and limited its power to change environmental practices.

That trade-off is vanishing. In the last year, investors have been able to put money into funds that mimic the risk and return on benchmark indexes, while slashing the amount of carbon emitted by the included companies. “We expect returns equal to — or we think could be superior to — what we get in the Russell 1000,” said DiNapoli, referring to an index of large American companies. “We’ll be assessing the returns, and make sure it keeps to the Russell 1000. Our goal is to put even more of our public equities into the fund.”

Goldman created the investment fund only for New York State. But similar funds introduced in 2014 or 2015 are open to other investors, although they have not yet attracted the capital to match New York State’s investment. And more are likely to come — especially after New York’s vote of confidence in a form of green investing that may become mainstream.

“Green investing” to most people still means divestment — selling stock in companies that produce fossil fuels, especially coal, the worst for climate change.

The movement for university divestment has been a great rallying cry and organizing tool for climate activism. As Bill McKibben, the co-founder of 350.org, said, it helps to revoke the social license of fossil fuel companies.

But even McKibben acknowledges that divestment doesn’t affect the stock prices of fossil-fuel companies — and it might not matter even if it did. The companies are so big that divestment has next to no financial impact on them.

It might be a very smart move for investors, however. In the short term, stocks of coal companies, and to a lesser extent, oil companies, are doing terribly. And while in the past, energy stock prices have been cyclical, that may no longer be true, especially with the new emissions goals countries just committed to in Paris. These companies are likely to leave large swaths of their assets in the ground. “Paris is saying that we’re moving to a low-carbon future,” said Mindy S. Lubber, president of Ceres, an organization that mobilizes investment and business leaders to fight climate change. “What is the financial strength of a Chevron or ConocoPhillips in the next 10 years?”

A second form of green investment is putting money into companies making products or services that reduce climate change: for example, solar- or wind-power producers, manufacturers of emission-cutting devices and systems, and companies that do carbon trading or energy-efficiency management. DiNapoli also announced that New York’s fund would invest some $1.5 billion more in its Green Strategic Investment Program, which already has $500 million in such companies.

This kind of direct investing in climate solutions is needed on a huge scale — Ceres calls for a “clean trillion” invested every year to comply with the goal of limiting the warming of the planet to 2 degrees Celsius. But it’s not for every investor. It’s risky — many of these companies are new and volatile. Despite the boom in solar energy, for example, American solar companies are being driven out of business by inexpensive equipment from China. And stock-picking comes with high management fees that cut into returns.

New York’s investment in Goldman’s fund is an example of a third way. The fund starts with the Russell 1000, excluding coal producers. Then it groups companies by sector, such as health care or information technology, and within each sector increases the shares of companies with the lowest emissions, and reduces those of companies with higher emissions. Goldman will periodically re-weight the fund to try to mimic the returns of the benchmark, but to do so in the lowest-carbon way possible. Goldman says the historical performance of the basket of stocks matches the performance of the Russell 1000 while reducing carbon emissions by 70 percent.

This is called index or passive investing because there is no active money manager trying to beat the market by picking stocks. Passive funds seek only to match the market, but they outperform active funds for investors 75 percent of the time, largely because the passive funds’ fees are much lower.

Goldman is following other asset management companies that have created passive low-carbon funds in the past year or so, including BlackRock, State Street, and Mellon Capital in the United States, and Amundi and Northern Trust in Europe. These funds were started with seed capital from United Nations, Swedish and French pension funds, the University System of Maryland and the McKnight Foundation, but they have yet to attract much follow-on investment. New York’s investment in Goldman’s fund is much bigger, and sends a confidence signal that is likely to be heard.

Why do these funds matter? First, because they could become very, very big. Second, all companies, not just energy producers, emit carbon, and burning carbon releases far more greenhouse gas than extraction of it does. So these funds use the market to encourage all companies to reduce their emissions. By putting money into the most environmentally responsible companies in each sector, they help those companies grow at the expense of less responsible ones, while creating an incentive for all to bring down emissions.

Green indexes are not new. FTSE had a version in 2001, and Standard & Poor’s started in 2009. But they are only catching on now. One reason is that we now have more than a decade’s worth of data about companies’ carbon footprints. The data comes largely from a nonprofit group called CDP, formerly the Carbon Disclosure Project.

Since 2003, CDP has been asking companies to provide information about their carbon emissions. CDP’s request for information to each company goes out under the signature of 822 major institutional investors. Requests go to every publicly traded company in the world, and many provide answers — 75 percent of the S&P 500, according to Paula DiPerna, special adviser to CDP North America, and companies that issue 55 percent of stocks traded worldwide. Although the information is self-reported, most of the responses have been audited, said DiPerna. For companies that don’t report to CDP, index providers work with environmental data analysts such as TruCost and Sustainalytics to estimate emissions.

Investors have long been able to choose indexes made of companies that are mid-sized, or companies located in Eastern Europe, or pharmaceutical manufacturers, or companies that are consistent with Islamic law. Now they can also choose low-carbon companies.

Can these funds be sure they will match the benchmark index? Nope. As every prospectus says, past performance is not a guarantee of future returns. But matching is easier to do with a low-carbon fund than with many other types. The portfolio is still broadly diversified, with carbon-efficient companies in each category. (Some funds exclude fossil fuel companies, and some don’t.)

Carbon-efficient companies, moreover, often outperform their less responsible counterparts; research that tracks companies over a long period found that those that had worked to improve their environmental, social or governance records did nearly 5 percent per year better than other companies. Other researchers found that these companies were less volatile and risky.

Related

There are other reasons for the current interest in low-carbon index funds. Institutional investors are increasingly moving money into passive funds to reduce fees, and universities are under pressure from students to do more than divest.

In October, the Obama administration made long-awaited changes in its guidance for private pension funds. The Bush administration had changed the guidance to compel pension fund managers to consider only financial returns when choosing investments. Now investors are free to consider a company’s environmental, social and governance records, as long as they do not compromise their fiduciary obligations.

For many pension fund managers, environmental factors are financial factors. Climate change already costs the world — and its corporations — trillions of dollars. In the long term, there is no greater financial risk, and long-term risk is exactly what pension fund managers are paid to worry about.

Pension fund managers aren’t alone. One in every six dollars invested in the United States is screened for environmental, social or governance factors, and the number is rising fast.

S&P, for example, is now taking climate considerations into credit ratings, the investment research firm Morningstar is calculating carbon ratings for its mutual funds, and MSCI is publishing the ratings of all 160,000 indexes it designs.

DiPerna worked with the oceanographer Jacques Cousteau in the 1970s. In 1979 she documented coral bleaching due to warming oceans; she’s been working on climate change, then, for nearly 40 years. She helped to establish carbon trading markets in Chicago and in China. “But I have never seen anything more important than the mainstreaming of environmental issues in the economy as we know it today,“ she said. “It’s not enough for the vanguard to act. And the mainstream has caught up to the vanguard. The financial services sector is ahead of the discussions in Paris.”

Not everyone is as optimistic. “I would say segments of Wall Street are ahead of Paris,” said 350.org’s Henn. “But people in the corner offices still treat it as a boutique approach.”

He also said that New York State’s DiNapoli “hasn’t said he’s divested from coal. He still has a billion invested in ExxonMobil. He says he’s doing shareholder engagement, so it’s O.K. We say: you’ve had two decades.”

The green index funds, Henn said, are only a start. “They’re looking at which oil companies are better because they don’t flare as much methane. That’s good, but if you’re still drilling in the Arctic? You wonder whether New York’s entire fund should be invested in a sustainable way. What’s happening with the other $180 billion in an era when it’s 70 degrees in Central Park on Christmas Eve?”